Dividend discount model (DDM)

Definition

The Dividend Discount Model (DDM) is a method used to value a stock by discounting predicted future dividend payments to their present value. This model assumes that dividends are the primary source of a stock's value.

5 Must Know Facts For Your Next Test

1. The basic formula for DDM is P = D / (r - g), where P is the price, D is the expected dividend, r is the required rate of return, and g is the growth rate of dividends.
2. DDM can be used only if a company pays dividends and those dividends are expected to grow at a constant rate.
3. There are variations of DDM including the Gordon Growth Model which assumes a constant growth rate.
4. The model heavily relies on accurate estimation of growth rates and required rates of return, which can be difficult to predict.
5. DDM may not be suitable for companies that do not pay regular dividends or have unpredictable dividend patterns.

Review Questions

• What is the basic formula used in the Dividend Discount Model?
• Why might DDM not be suitable for valuing certain companies?
• What key assumptions must hold true for the Gordon Growth Model?

Related terms

Dividend Yield: The annual dividend payment divided by the current stock price, expressed as a percentage.

Intrinsic Value: The perceived or calculated true value of an asset based on fundamental analysis.

Required Rate of Return: The minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project.